29

The Monetary System (II)

PowerPoint Slides prepared by:

Andreea CHIRITESCU
Eastern Illinois University

2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 0
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 The Money Supply
The money supply (or money stock):
the quantity of money available in the economy
What assets should be considered part of the
money supply? Two candidates:
Currency: the paper bills and coins in the
hands of the (non-bank) public
Demand deposits: balances in bank accounts
that depositors can access on demand by
writing a check

THE MONETARY SYSTEM 1

 Money in the U.S. Economy
Measures of money stock
M1
Demand deposits, Travelers checks
Other checkable deposits, Currency
M2
Everything in M1
Savings deposits, Small time deposits
Money market mutual funds
A few minor categories

2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as 2
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Banks and Money Creation

While private individuals and firms are not

permitted to print currency, private actions affect
the total supply of money in the economy.
Banks create money as a byproduct of their daily
business activity.
Roles of banks in macroeconomics
Critical participants in the loanable funds market
(discussed previously)
Contribute in the money supply process
Business of Banking
Interest Rates on Bank
Deposits and Loans
Figure 30.3 here
Bank Balance Sheet
Loans: primary interest-earning use of bank funds
Reserves: bank deposits set aside and not lent out
Include currency at the vault and holdings at their bank (the
Federal Reserve)
Bank Reserves

Fractional reserve banking

Banks only hold a fraction of deposits on reserve.
An alternative would be 100% reserve banking, where
banks dont loan out deposits.
Typically, banks only keep 10% on reserve.
Bank Reserves

Cost of holding reserves

Before 2008, reserves earned no interest.
The opportunity cost of holding reserves is the interest
payments never collected on loans never made.
Fractional Reserve Banking

Figure 30.5 here





Banks reserves
= Cash in vault ()
+ Banks deposits at the central bank
()

THE MONETARY SYSTEM 10

Bank Reserves

Two reasons banks hold reserves

Banks need to accommodate customer withdrawals.
Federal Reserve requires banks to hold a fraction of
their deposits on reserve.
This fraction is called the required reserve ratio (rr).
The current rr is 10%
Bank run
Occurs when many depositors attempt to withdraw
funds from a bank at one time
Could be the result of word spreading that a bank is
having trouble meeting withdraw requests
May end with bank in default
Bank Reserves

To determine the dollar amount of required

reserves:
Required reserves = rr deposits

Any reserves above the required level are called

excess reserves. Excess reserves are typically
small.

Excess reserves = total reserves required reserves

How Banks Create Money

Two important points so far:

The money supply includes both currency and bank
deposits.
Our modern banking system is a fractional reserve
system, meaning that banks loan out a fraction of the
deposits they take in.
Other notes
Banks function as financial intermediaries.
Banks do not mint currency.
 Bank T-account
T-account: a simplified accounting statement
that shows a banks assets & liabilities.
Example: FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10 Deposits $100
Loans $ 90

Banks liabilities include deposits,

assets include loans & reserves.
In this example, notice that R = $10/$100 = 10%.
THE MONETARY SYSTEM 14
Banks and the Money Supply: An Example
Suppose $100 of currency is in circulation.
To determine banks impact on money supply,
we calculate the money supply in 3 different cases:
1. No banking system
2. 100% reserve banking system:
banks hold 100% of deposits as reserves,
make no loans
3. Fractional reserve banking system

THE MONETARY SYSTEM 15

Banks and the Money Supply: An Example
CASE 1: No banking system
Public holds the $100 as currency.
Money supply = $100.

THE MONETARY SYSTEM 16

Banks and the Money Supply: An Example
CASE 2: 100% reserve banking system
Public deposits the $100 at First Bank (FB).
FB holds
100% of FIRST BANK
deposit Assets Liabilities
as reserves:
Reserves $100 Deposits $100
Loans $ 0
Money supply
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system,
banks do not affect size of money supply.
THE MONETARY SYSTEM 17
Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
Suppose R = 10%. FB loans all but 10%
of the deposit:
FIRST BANK
Assets Liabilities
Reserves $100
10 Deposits $100
Loans $ 90
0

Money supply = $190 (!!!)

Depositors have $100 in deposits,
Borrowers have $90 in currency.
THE MONETARY SYSTEM 18
Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
How did the money supply suddenly grow?
When banks make loans, they create money.
The borrower gets
$90 in currency (an asset counted in the
money supply)
$90 in new debt (a liability)

A fractional reserve banking system

creates money, but not wealth.

THE MONETARY SYSTEM 19

Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
Suppose borrower deposits the $90 at Second
Bank (SB).

Initially, SBs SECOND BANK

T-account Assets Liabilities
looks like this: Reserves $ 90
9 Deposits $ 90
Loans $ 81
0

If R = 10% for SNB, it will loan all but 10% of the

deposit.

THE MONETARY SYSTEM 20

Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
The borrower deposits the $81 at Third Bank (TB).

Initially, TBs THIRD BANK

T-account Assets Liabilities
looks like this: Reserves $ $8.10
81 Deposits $ 81
Loans $72.90
$ 0

If R = 10% for TNB, it will loan all but 10% of the

deposit.

THE MONETARY SYSTEM 21

Banks and the Money Supply: An Example
CASE 3: Fractional reserve banking system
The process continues, and money is created with
each new loan.

Original deposit = $ 100.00 In this

FB lending = $ 90.00 example,
SB lending = $ 81.00 $100 of
reserves
TB lending = $ 72.90
.. .. generates
. . $1000 of
Total money supply = $1000.00 money.

THE MONETARY SYSTEM 22

 The Money Multiplier
Money multiplier: the amount of money the
banking system generates with each dollar of
reserves
(deposit expansion multiplier)
The money multiplier equals 1/R.
In our example,
R = 10%
money multiplier = 1/R = 10
$100 of reserves creates $1000 of money

THE MONETARY SYSTEM 23

ACTIVE LEARNING 1
Banks and the money supply
While cleaning your apartment, you look under the
sofa cushion find a $50 bill (and a half-eaten taco).
You deposit the bill in your checking account.
The Feds reserve requirement is 20% of deposits.
A. What is the maximum amount that the
money supply could increase?
B. What is the minimum amount that the
money supply could increase?

24
ACTIVE LEARNING 1
Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
If banks hold no excess reserves, then
money multiplier = 1/R = 1/0.2 = 5
The maximum possible increase in deposits is
5 x $50 = $250
But money supply also includes currency,
which falls by $50.
Hence, max increase in money supply = $200.
25
ACTIVE LEARNING 1
Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
Answer: $200
B. What is the minimum amount that the
money supply could increase?
Answer: $0
If your bank makes no loans from your deposit,
currency falls by $50, deposits increase by $50,
money supply does not change.
26
 Money Multiplier


= =

Money = Currency + Deposits

currency, money
multiplier?
Monetary Base ()
= Currency + Reserves
=
THE MONETARY SYSTEM 27
 Monetary base high-powered money (
)
+
=
=
+

+
+
<

(because deposit >
reserve)
< 1/

THE MONETARY SYSTEM 28

 The monetary base is the sum of currency in circulation
and bank reserves.
The money multiplier is the ratio of the money supply
to the monetary base.
 Money supply =
money multiplier x Monetary base
The central bank controls money supply by
Affecting monetary base
Affecting the multiplier
 The Feds 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase
and sale of U.S. government bonds by the Fed.
To increase money supply, Fed buys govt bonds,
paying with new dollars.
which are deposited in banks, increasing reserves
which banks use to make loans, causing the
money supply to expand.
To reduce money supply, Fed sells govt bonds,
taking dollars out of circulation, and the process
works in reverse.

THE MONETARY SYSTEM 31

Open Market Operations
Quantitative Easing

End of 2008, worst quarter in U.S. in 50 years

Real GDP down 8.9%, unemployment up
Fed decided additional measures needed.
Quantitative easing
Targeted use of open market operations where the
central bank buys securities specifically targeted in
certain markets
Targeted the housing market
Unprecedented; it amounts to the Fed
printing trillions of new dollars and putting
them in targeted sectors.
Quantitative Easing
20072012
 The Feds 3 Tools of Monetary Control
2. Reserve Requirements (RR):
affect how much money banks can create by
making loans.
To increase money supply, Fed reduces RR.
Banks make more loans from each dollar of reserves,
which increases money multiplier and money supply.
To reduce money supply, Fed raises RR,
and the process works in reverse.
Fed rarely uses reserve requirements to control
money supply: Frequent changes would disrupt
banking.
THE MONETARY SYSTEM 35
 The Feds 3 Tools of Monetary Control
3. The Discount Rate:
the interest rate on loans the Fed makes to banks
When banks are running low on reserves,
they may borrow reserves from the Fed.
To increase money supply,
Fed can lower discount rate, which encourages
banks to borrow more reserves from Fed.
Banks can then make more loans, which increases
the money supply.
To reduce money supply, Fed can raise discount rate.

THE MONETARY SYSTEM 36

 The Feds 3 Tools of Monetary Control
3. The Discount Rate:
the interest rate on loans the Fed makes to banks
The Fed uses discount lending to provide extra
liquidity when financial institutions are in trouble,
e.g. after the Oct. 1987 stock market crash.
If no crisis, Fed rarely uses discount lending
Fed is a lender of last resort.

THE MONETARY SYSTEM 37

 The Federal Funds Rate
On any given day, banks with insufficient reserves
can borrow from banks with excess reserves.
The interest rate on these loans is the federal
funds rate. ()
The FOMC uses OMOs to target the fed funds
rate.
Many interest rates are highly correlated,
so changes in the fed funds rate cause changes in
other rates and have a big impact in the economy.

THE MONETARY SYSTEM 38

The Fed Funds Rate and Other Rates, 1970-2008

20 Fed funds
prime
15 3-month Tbill
mortgage
(%)

10

0
1970 1975 1980 1985 1990 1995 2000 2005
Monetary Policy and the Fed Funds Rate
To raise fed funds The Federal
rf Funds market
rate, Fed sellsFederal
funds rate
govt bonds (OMO). S2 S1

This removes 3.75%

reserves from the
banking system, 3.50%
reduces supply of
federal funds,
causes rf to rise. D1
F
F2 F1
Quantity of
federal funds
THE MONETARY SYSTEM 40
Problems Controlling the Money Supply
If households hold more of their money as
currency, banks have fewer reserves,
make fewer loans, and money supply falls.
If banks hold more reserves than required,
they make fewer loans, and money supply falls.
Yet, Fed can compensate for household
and bank behavior to retain fairly precise control
over the money supply.

THE MONETARY SYSTEM 41

 Bank Runs and the Money Supply
A run on banks:
When people suspect their banks are in trouble,
they may run to the bank to withdraw their funds,
holding more currency and less deposits.
Under fractional-reserve banking, banks dont
have enough reserves to pay off ALL depositors,
hence banks may have to close.
Also, banks may make fewer loans and hold more
reserves to satisfy depositors.
These events increase R, reverse the process of
money creation, cause money supply to fall.
THE MONETARY SYSTEM 42
 Bank Runs and the Money Supply
During 1929-1933, a wave of bank runs and
bank closings caused money supply to fall 28%.
Many economists believe this contributed to the
severity of the Great Depression.
Since then, federal deposit insurance has helped
prevent bank runs in the U.S.
In the U.K., though, Northern Rock bank
experienced a classic bank run in 2007 and was
eventually taken over by the British government.

THE MONETARY SYSTEM 43

 Central Banks & Monetary Policy
Central bank: an institution that oversees the
banking system and regulates the money supply
Monetary policy: the setting of the money
supply by policymakers in the central bank
Federal Reserve (Fed): the central bank of the
U.S.

THE MONETARY SYSTEM 44

 Central Banks
Sveriges Riksbank (Sweden, 1668)
Bank of England (UK, 1694)
U.S. Federal Reserve System (1914)
European Central Bank
Central Bank of the Republic of China (Taiwan)
Bank of Japan
Peoples Bank of China
 The Functions of a Central Bank
The Governments Bank
Manages the finances of the government
Through interest rates, controls the availability of
money and credit
The Bankers Bank
Guarantees that sound banks can do business
Operates a payments system for interbank
payments
Oversees financial institutions
 The Structure of the Fed
The Federal Reserve System consists of:
Board of Governors
(7 members), located in Washington, DC
12 regional Fed banks,
located around the U.S.
Federal Open Market Committee (FOMC),
includes the Board of Governors and
presidents of some of the regional Fed banks
The FOMC decides monetary policy.

THE MONETARY SYSTEM 47

The Federal Reserve System
 Board of Governors ()

(governor)
14

THE MONETARY SYSTEM 49

 Federal Reserve Banks ()

THE MONETARY SYSTEM 50

 (Federal Open Market
Committee, FOMC)


FOMC 127
4()
(federal funds rate

THE MONETARY SYSTEM 51

Federal Reserve is a Bank
for Banks
 New York Fed

John McClane
16-53
FRB of NY: The Gold Vault

250 million ounces

Over $85 billion at
current market prices
10% of all the gold that
has ever been taken
out of the ground
One bar weights about
400 ounces

16-
54
World official gold holding (2017/4)
1 USA 8133.5
( tonnes)
2 Germany 3377.9
6 China 1482.6
7 Switzerland 1040.0
9 Japan 765.2
12 ECB 504.8
13 Taiwan 423.6

1961711945
10

1979

 /: 5
: 11-155-7
()4
: 5-7


---
(
)
(2004
)

THE MONETARY SYSTEM 58

 The Objectives of a Central Bank
Low, stable inflation
High, stable growth
Financial system stability
Stable interest rate
Stable exchange rate